Bond market braces for bear hug

Expects long rally to end; eyes now on Trump & Fed moves in the US & what Budget to say on deficit

The bond market is slowly preparing for a lacklustre market, expecting the recent rally, the longest since 2003, to get over.

Indian bonds have outperformed emerging market (EM) peers in recent months, despite outflow from foreign investors. Abundant liquidity, aided by the demonetisation drive, and inadequate avenues to deploy these funds, have fuelled the rally till now. With slowing growth, there were also hopes of steep rate cuts by the Reserve Bank of India (RBI) but all those factors are fading. 

The yield on the 10-year bond started the year at 7.73%. On November 24, this had dropped to 6.19%, a multi-year closing low, due to huge liquidity in banks’ hands after demonetisation. Since then, yields have climbed; closure was at 6.47% on Friday. As yields rise, the prices of bonds fall. 

This is despite the government lowering its borrowing programme for the rest of the year by Rs 18,000 crore and trimming the borrowing from short-term treasury bills by Rs 52,000 crore. 

“This indicates bleak appetite, in spite of good domestic market fundamentals, represented by comfortable liquidity, benign inflation and a favourable demand-supply balance,” said Ram Kamal Samanta, vice-president for treasury at SBI DFHI. He says the chance is now dimmer of a sharper rate cut by RBI. The central bank is likely to be cautious, with the new inflation mandate (not more than 4%), rising global crude oil and commodity prices, the depreciating trend in EMs' currencies and expectations of faster rate increases by the US Federal Reserve.

Investment bank Nomura has said the fact that demonetisation has improved liquidity would mean RBI purchases less of bonds from the secondary market, a dampener. Bond dealers will also be watching the initial run of the Donald Trump administration in America, to gauge how his policies would prompt the US Fed to respond. Trump has promised huge infrastructure spending, which would bring back growth and, thereby, some inflation. This should prompt the Fed to raise rates, leading to more outflow from EMs. So, the scope for RBI rate cuts would be curtailed. 

 “As further rate cuts become less likely, we expect investors to shift from duration to carry-based strategies, effectively shifting bond demand from the longer end to the shorter,” says a Nomura report.

One important and immediate factor the bond market is keenly watching for is the Union Budget here. While the government has managed to stick to its target of a 3.5% fiscal deficit to gross domestic product in 2016-17, it remains to be seen what it has to say about next year’s target, which is 3% by the current rule. A panel is due to recommend on this early next week and the market is waiting to see if the fixed target is converted into a range or a revised number.

“The bond market is more concerned about these (fiscal deficit management) numbers than anything else,” said Rana Kapoor, managing director of YES Bank, on Thursday. “A range won’t be good. But, if it is rule-based, there is no harm if the target is revised up a little bit, say 3.3% of GDP. A fixed number will also comfort the bond market.”